How to Decide When to Switch From Bonds to Annuities

While savings accounts or certificates of deposit should get a bump from continued interest rate hikes, the bonds in your portfolio may not fare as well.

The State Street Investor Confidence Index, which measures investor sentiment, lost 3.4 points in October, falling to 84.4 on the heels of the Federal Reserve’s September rate hike. A third-quarter survey by The Conference Board, a nonprofit research association, found that CEO confidence in the U.S. economic outlook declined because of upward movements in the federal funds rate.

“The Federal Open Market Committee projects one more rate hike in 2018, and three more in 2019,” says Dylan Huang, head of retail annuities at New York Life Insurance Company. “If they’re true to their word and interest rates continue to rise as a result, bondholders will see the value of their holdings decline.”

Huang says this is concerning for retirees who may be invested more heavily in bonds and rely on their portfolios for income. Investors may be wondering if shifting some allocation away from bonds into annuities can safeguard income as rates rise. Whether to do so hinges largely on timing and how much of a lead-up time an investor has before retirement.

[Read: Know When It’s Time to Sell a Stock.]

“Bonds can be an effective investment even in a rising interest-rate environment if the duration of exposure is laddered from one to 10 years out,” says Jason Ware, co-founder and head of trading at San Francisco-based 280 CapMarkets. “With this strategy, as an investor’s bonds mature and rates rise, maturing principal payments can be reinvested to keep the 10-year ladder consistent, allowing them to systematically capture those higher yields in their bond portfolio.”

That can be a sound strategy. But for some investors, an annuity may seem more appealing. Here are a few ways to decide if switching out of bonds for annuities makes sense for your portfolio as interest rates rise.

Get clear on your portfolio’s purpose.

There are different types of annuities to choose from and some are better suited for replacing bonds than others.

“Annuities can be structured many different ways to reflect individual financial objectives,” says Andy Whitaker, a financial planner at Gold Tree Financial in Jacksonville, Florida. “These can include, but are not limited to, a protected income stream, growth with protection of principal, insured death benefits, etc.”

[Read: How to Protect Your Investments From Inflation.]

Before moving from bonds to annuities, bondholders may want to consider their objectives and how a particular type of annuity can help achieve their goals. Income annuities, for example, may be preferable for investors who have already retired or are nearing retirement in search of a reliable income to replace declining bond yields.

Huang says income annuities behave like “super bonds,” making them a good addition for three distinct reasons.

“They’re duration matched to the investor’s life, meaning they provide guaranteed lifetime income,” Huang says. “They’re uncorrelated with capital markets, which means the income they pay out is guaranteed and will not fluctuate with the market. And they may offer higher cash flows than bonds of similar credit quality due to mortality credits.”

Consider the pros and cons of variable and fixed annuities.

Following Huang’s description of income annuities, they may be suitable for bondholders who are focused primarily on maintaining or generating income streams in a rising rate environment.

On the other hand, for those working on asset accumulation, Huang says a variable annuity may be beneficial, since it allows investors to remain invested in the market without the fear of losing their initial investment.

“These products help investors grow their assets via market participation, while also providing principal protection,” Huang says. “This is a great solution for investors who need growth, but want to minimize the impact equity market volatility can have on their portfolios.”

But there is a caveat. Variable annuities don’t offer a guaranteed rate of return. For someone who wants to blend some of the key benefits of an income annuity with that of variable annuities, a fixed-index annuity can offer a compromise.

“A fixed-index annuity offers downside protection, so you can’t lose any principal,” says John Woods, president and owner of Southport Capital in Atlanta. “Investors can also get the upside potential without a cap of the Standard & Poor’s 500 index.”

Woods says for those considering a fixed-index annuity, limit it to no more than 30 percent of a total portfolio regardless of age or time away from retirement. As with any investment, experts advise keeping in mind that the overall balance of equities to fixed-income investments in a portfolio, as it correlates to age, risk tolerance and risk capacity.

[Read: How to Find a Financial Advisor if You’re Not Rich.]

Don’t give up on bonds entirely.

One thing to remember about annuities is that there are trade-offs, Whitaker says. Surrender penalties, for example, translate into lack of liquidity. There’s also the cost to consider.

“When measured appropriately and when benefits outweigh trade-offs, annuities can be a preferred financial alternative,” he says. They may lose some of their luster, he says, when cost or lack of liquidity overshadow the benefits.

Huang points out that “unlike most traditional asset classes, income annuities have limited liquidity options and do not allow for growth potential.” Investors may consider maintaining a position in bonds as rates rise to offset those drawbacks. The question is they must decide which bonds they want to hold.

“In this economy, I recommend buying good-quality corporate bonds for qualified accounts,” Woods says. “For nonqualified accounts, I would look at some short-term municipal bonds, investment grade-rated or better.”

Ware’s recommendation is to focus on high-grade bonds with lower leverage profiles. “As rates go up, lesser credits tend to feel more pressure,” he says. “Similarly, those that are more reliant on capital markets for their borrowing come under more strain as their cost to borrow rises, which can further deteriorate the balance sheet.”

He also points to book yields as another important consideration when deciding which bonds to hold. “Those with the highest book yields and quality should be the bonds the investor keeps.”

Whitaker says that short-term bonds are usually less susceptible to loss of value with interest rate increases. He notes, however, that the current rate environment has been an exception to that rule.

“Since the first of this year, bonds with short maturities have lost value as well,” Whitaker says. “This being the case, it isn’t likely that you can say, definitively, that a certain class of bonds would be best to swap for annuities.”

Thinking in terms of the broader economic outlook can help when deciding between bonds and annuities.

“If the concern is not just interest rate increases, but also includes economic risks culling the higher risk bonds in a portfolio might be a good move, whether they’re swapped for annuities or not,” he says.

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How to Decide When to Switch From Bonds to Annuities originally appeared on usnews.com